Thursday, 3 January 2013

Did Ricardian Equivalence kill the Pigou effect?

For macroeconomists

After
the last time the world got into a liquidity trap, there was a debate about
whether price flexibility would be sufficient to get us out of the trap. That debate tended to assume a fixed
money supply. With that assumption, the answer today would be yes, if falling
prices raised inflation expectations (given long run neutrality) and therefore
reduced real interest rates. Back then that story was not so popular, perhaps
because the debate pre-dated rational expectations. Instead the argument at the
time focused on the Pigou or Real Balance effect. Falling prices raised the
value of outside money, so everyone would feel wealthier and spend more.

We
do not hear this argument so much nowadays. I have not seen this discussed in
the advanced textbooks I know well (for example neither term is in the index ofRomer orObstfeld and Rogoff), so I was wondering why
that was. Is the Pigou effect not what it was once thought to be? I could not
find a clear answer to this question anywhere, but of course that may be my
failing. So here are my thoughts, but they come with the possibility that I
have just missed something. If I have, I will rewrite the post accordingly.

What
I did find were a few papers that appeared to suggest that Ricardian
Equivalence (REq) killed the Pigou effect. Here is a quote from apaper
by Peter Ireland. After talking about REq, he writes

“Less
widely appreciated, however, is a closely related finding, presented most
explicitly by Weil (1991) but also implicit in earlier work by Sachs (1983) and
Cohen (1985). These authors show that government-issued fiat money will not be
perceived as a source of private-sector wealth if the households owning that
money are the same households that, first, receive all of the transfers or pay
all of the taxes associated with future changes in the money supply and that,
second, incur all of the opportunity costs associated with carrying the money
stock between all future periods.

We
are used to the idea of Ricardian Equivalence implying that government debt is
not net wealth. Essentially consumers internalise the government’s budget constraint.
But that argument applies to outside money as much as government debt. We can
replace initial values of debt and money by the discounted future stream of
primary surpluses they support.”

The
easiest way to describe REq is that the infinitely lived representative
consumer consolidates the government’s intertemporal budget constraint (IBC)
into its own. Suppose this consumer owns some nominal (non-indexed) government
debt, and the price level falls. Is that consumer better off? The real value of
the future interest they receive on that debt will be higher, but this will be
offset by the higher taxes in real terms that the government will raise to pay
for this. The same argument applies to the higher real redemption value of the
debt.

Ireland
argues that exactly the same points can be made about outside money. Suppose
money pays no interest, but consumers hold it because of the liquidity services
it provides.

But
if the consumer already has all the liquidity services they need (as they do in
a liquidity trap), a fall in prices that creates more of this asset in real
terms does not make the consumer better off on this account. So what about the
redemption value of the additional real balances?

Here
I’m inclined to think that money is different from government debt. In a paper[1] that I do not think has
been published, Willem Buiter argues that money is irredeemable. The government
only promises to redeem money with itself. So if I get a tax cut that is
financed by printing money rather than issuing debt, there is no offsetting
future tax liability. For this reason, money – unlike government debt – is net
wealth for the consolidated public and private sectors.

Now
a standard response is to say that a money financed tax cut does not make the
consumer better off because the price level will rise, reducing the purchasing
power of that money. It seems to me that is a different argument to REq – it
requires going beyond just thinking about budget constraints. It is also an
argument that does not apply to the Pigou effect, which is what happens if
prices fall, raising the value of real balances.

Does
the irredeemable nature of money rescue the Pigou effect from the REq argument?
Yes and no. There is a crucial difference between Buiter’s analysis and the
traditional view. In Buiter, it is the present
discounted value of the terminal stock of base money that is net wealth for
the consolidated private and public sectors, rather than its current value. To
see why this matters, consider the liquidity trap case again.

As
we have already noted, there is no liquidity trap in the flexible price case
when the government holds the nominal stock of money constant, because falling
prices today imply higher expected inflation. We do not need a Pigou effect.
But the more interesting case, which I have talked about before,
is where the government or central bank has an inflation target. In this case
the authorities prevent inflation expectations rising, so real interest rates
do not fall.

In
that case nominalmoney will not be held constant when prices
fall. Instead, the authorities will contract the nominal money stock in
line with falling prices, to make sure inflation does not rise. As a result,
there will be no increase in consumption, because the terminal value of nominal
money falls, and its real value stays constant. Or, to put the same point
another way, higher future taxes required to reduce the money stock will offset
the wealth impact of higher current real money balances. There is no Pigou
effect.

This
is all terribly stylised and unrealistic, so there is no need to add comments
that just point this out. However, I hope I’m not the only one who thinks this
thought experiment is interesting. I also think that the proposition that inflation targets prevent macroeconomic ‘self-correction’ even when prices are flexible has a symbolic importance.

The way to think about this is an unanticipated negative shock that drives down prices before monetary policy can react. Now the thing about inflation targeting, as opposed to price level targeting, is that this is water under the bridge - the monetary authorities only care about future inflation. So they try an avoid prices rising again.

It's some kind of price-flexibility which puts the world inside the liquidity trap. The beginning of the Great Recession, it's a Fisherian story, but not just any one, it's a debt-deflation story. Falling prices raised deflation expectations. Everyone would feel wealthier and spend less. Everybody panics and sells assets to stay liquid.

Buiter discussed this in his Hahn lecture in 2005 where the Pigou Effect was considered one of two monetary "ghosts": http://www.willembuiter.com/hahn.pdf, see pages C9-10. Indeed, there is no Pigou effect as traditionally defined, but "With irredeemable government fiat money, base money is net wealth in the sense that the present discounted value of the terminal stock of money balances ispart of the private sector’s comprehensive wealth after consolidation of the HIBC and GIBC. Thus, there exists a weak form of the real balance effect even in the representative agent model with rational expectations."

Worth also recalling Tobin's Jahnsson Letures, published as "Asset Accumulation and Economic Activity" where he revisits the Pigou versus Keynes versus Fisher effects. Capsule summary: The stock of outside money is too small, so Pigou effect no big deal. Whereas inside money, and the relative financial position of debtors versus creditors that net out in the aggregate, would reveal relative position of debtors to deteriorate because of falling prices -- hence Irving Fisher's debt deflation theory. In other words, you need to break Buiter's representative agent assumption. This could cause the IS curve to change slope etc.

Fascinating, thanks for the paper. You realize that even to somebody with a smattering of economic knowledge, like myself, your post reminds one of the differences between iconoclasts and their opponents in Byzantine medieval debates? Or even more obscure camps. That's the problem with economics: the tiniest perturbation changes everything, like for example the assumptions behind the REq (e.g. inter-temporal transfers)

Robert Barro (link: http://dash.harvard.edu/bitstream/handle/1/3451399/Barro_AreGovernment.pdf?sequence=4 ) argued that due to Ricardian Equivalence in the presence of an operative bequest motive the public is not fooled into thinking they are richer when the government issues bonds to them, because government bond coupons must be paid from increased taxation. Therefore, he said that:1. At the microeconomic level, the subjective level of wealth would be lessened by a share of the debt taken on by the national government. 2. Bonds should not be considered as part of net wealth at the macroeconomic level. 3. Therefore: There is no way for the government to create a "Pigou effect" by issuing bonds, because the aggregate subjective level of wealth will not increase.

"Here I’m inclined to think that money is different from government debt. In a paper[1] that I do not think has been published, Willem Buiter argues that money is irredeemable. The government only promises to redeem money with itself. So if I get a tax cut that is financed by printing money rather than issuing debt, there is no offsetting future tax liability. For this reason, money – unlike government debt – is net wealth for the consolidated public and private sectors."

This argument is wrong. Printing money debases the currency and inflation in this case is a hidden form of taxation (liability).

Printing money does not necessarily debase the currency and cause inflation. It is necessary for economic growth for the money supply to increase. The key issue is to increase it at roughly the same rate as the productive capacity of the economy. If there is inflation you are increasing it too fast. If there is deflation and/or unused productive capacity you are increasing it too slowly. It is not rocket science.